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Where credit's due

Published in Automated Trader Magazine Issue 29 Q2 2013

Back in the 'good old days', life seemed so simple: dealers warehoused vast amounts of corporate bonds, and investors picked up the telephone when they wanted to buy or sell. But capital requirements and regulation have led to a dramatic fall in banks' balance sheets and the buy-side is being asked to play a bigger role to boost liquidity. As electronification takes hold, can the elusive all-to-all model take off or is something else needed? Adam Cox reports.

Where credit’s due

There is a data series from the New York Federal Reserve that fixed income executives frequently cite. It shows the amount of corporate bonds with maturities of more than a year held by primary dealers. Since these are dealers we're talking about, the aggregate total is a useful illustration of available liquidity. In October 2007, a year before the collapse of Lehman Brothers, those holdings topped $230 billion. By the time the crisis was unfolding, the total was hovering just above $100 billion. Earlier this year it was less than half that.

George Harrington

George Harrington

"From our standpoint, the key really is market readiness. The paradigm shift will occur when you have the buy-side going from liquidity-taking to liquidity-provision."

The financial crisis and the resulting regulatory changes have ushered in a fundamental shift in the way corporate bond trading works. As banks have had to reduce their balance sheets, a good deal of bond trading power has shifted to the buy-side. But asset managers have been unwilling or unable to effectively wield that power to date. Add to that some of the complexities inherent in the corporate bond market, and the slow pace of adoption of electronic trading relative to other asset classes, and the result has been illiquid markets.

"You have to look at the picture from a 30,000 feet perspective," said Robert Urtheil, head of Europe and Asia at bond trading platform MarketAxess. "The corporate market or the credit market is today where many other markets were 10 years ago."

Corporate bonds, he said, are seen more as an investment vehicle and the degree of electronification lags behind other asset classes.

"In the credit market, you literally have securities which haven't been traded for days, weeks or even months," Urtheil added. "So to take the risk, to put your finger out with a price, versus just asking for a price, is obviously something an investor will think twice about."

George Harrington, head of global fixed income trading at Bloomberg, sees those behavioural factors as a core issue in terms of the market's development.

"From our standpoint, the key really is market readiness. The paradigm shift will occur when you have the buy-side going from liquidity-taking to liquidity-provision."

But buy-side trepidation is only one of the obstacles standing in the way of a vibrant corporate bond marketplace. The goal of having an all-to-all market for corporate bonds, akin to an exchange scenario for equities, has also long been complicated by simple logistics.

Robert Urtheil

Robert Urtheil

"You have to look at the picture from a 30,000 feet perspective. The corporate market or the credit market is today where many other markets were 10 years ago."

There may be one General Electric issue of common stock that the investment community cares about, but there are about 600 different GE bond issues, all of which have varying coupons and maturities.

"On average in Europe, you have about 50,000 to 70,000 items outstanding in the credit market. That alone leaves you with a marketplace that has to work differently," Urtheil said, contrasting it with a liquid listed derivatives market which might be dominated by a handful of products accounting for most of the volume. "So it is just more difficult in an opaque, illiquid market to make prices, and this is where asset managers see the benefit of the market-making capabilities of the banks," he said.

Complicating the problem is a complex competitive landscape, with single dealer platforms, multi-dealer venues and buy-side initiatives all engaged in a high-stakes scramble for liquidity. As a result, the word that comes up most frequently among executives describing the process underway is 'evolution'. This is not just a battle for market share, but rather one to see how the species will adapt to colder climes.

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